Unfortunately for the RBI the weakening of the INR has been caused both by a large current account deficit (which has been in place for several quarters) and a sudden reversal of foreign flows into both equity and debt markets. Cumulative 2013 Equity flows have fallen from $15.3 bln on June 10th to $12.3 bln on July 26th, one of the sharpest withdrawals of capital in recent years. The picture for bonds is even worse, with peak flows of $5.58 bln on May 21st turning into a net outflow of -$3.25 bln on July 26th, the largest ever YTD outflow of fixed income investments since the data starts a decade ago.

In other words India would appear to have gone “back to the future”, suffering from an old fashioned currency crisis, with the RBI responding in the manner of a EM central bank of 15 or 20 years ago. The clear danger is that monetary tight policy acts to worsen economic conditions which in turn further undermines investor confidence. Under such circumstances the currency could continue to weaken even as the RBI acts to protect its value, making the policy an exercise in futility.

India’s current account deficit (4.8% GDP in FY 20131) remains uncomfortably close to historical highs and way above the gap of 3% during the 1991 BOP crisis. With the fiscal deficit at 7.2% of GDP, the ‘twin’ deficit stood at 12% GDP in FY 2013, just a touch lower than the 1991 high of 14% of GDP. Apart from a weak currency adding to fuel subsidy expenditure, the proposed Food Security Bill may lead to an additional burden on the fiscal balances. The Bill, if passed and implemented, may also worsen the current account balance, which is already under pressure from a lacklustre external demand and relatively high global oil price. Indeed, with QE ‘tapering’ the talk of the town, investors are getting increasingly wary of financing the deficit and a potential re-run of the 1991 BOP Crisis.

We do not pencil in a 1991 style BOP ‘crisis’ in our base case forecasts with a very low probability of such shocks in the medium-term. The 1991 crisis was the result of an insalubrious concoction of fiscal profligacy, rigid controls and political instability which led to worsening external balances. The latter was exacerbated with the dissolution of the Soviet Union, the largest contributor to India’s export growth. The trigger was a spike in global oil prices (170% increase in less than four months) during the 1990-91 Gulf War, causing the current account balance to plummet amidst sticky imports. With a confluence of deteriorating domestic and external fundamentals, foreign financing became elusive, putting pressure on the capital account balance. The stock of FX reserves dwindled and could cover less than 2 weeks of imports at the trough, forcing the country to seek external aid.

Last week, JPMorgan’s Bharat Iyer and team contemplated what India’s falling currency means for its stock market:

The pace of downgrades for corporate earnings estimates has intensified over the last quarter. Despite these cuts, we believe current earnings growth expectations of about 12% for FY14E are demanding in relation to both economic growth forecast and the recent deterioration in key macro variables – particularly the currency and interest rates. Our macro models suggest earnings growth of about 6-8% for FY14E.

Sectors that we believe are vulnerable to meaningful earnings downgrades are Consumer and Financials. An improving global growth outlook and INR depreciation should however be supportive of and lead to earnings.

We remain cautious on Indian equities, particularly the rate sensitive domestic sectors. Our cautious stance since late January is premised on growth numbers disappointing and limited policy stimuli. Our portfolio stance is biased towards Energy, IT Services, Healthcare, and ‘Sin’ stocks in the Consumer space.

About Emerging Markets Daily

Emerging markets have been synonymous with growth, but the outlook for individual nations is constantly changing. Countries from Brazil and Russia to Turkey face challenges including infrastructure bottlenecks, credit issues and political shifts. The Barrons.com Emerging Markets Daily blog analyzes news, data and research out of emerging markets beyond Asia to help readers navigate the investment landscape.

Barron’s veteran Dimitra DeFotis has been blogging about emerging market investing since traveling to India and Turkey. Based in New York, she previously wrote for Barron’s about U.S. equity investing, including cover stories and roundtables on energy themes. Dimitra was among the first digital journalists at the Chicago Tribune and started her career as a police reporter at the Daily Herald in the Chicago suburbs. Dimitra holds degrees from the University of Illinois and Columbia University, where she was a Knight-Bagehot Fellow in the business and journalism schools.